Opinion: Not all is as it seems in the space

NatWorden

There’s no doubt that master-limited partnerships (MLPs), like Boardwalk Pipeline Partners
BWP, -1.69%
have tempted many retirees and other investors who depend on their investment portfolio for income. This extended period of rock-bottom interest rates orchestrated by the Federal Reserve to support the post-bubble economic recovery is a real nail biter for income investors who based their financial planning on a normal interest-rate environment.

With MLPs typically trading at higher yields averaging between 5% and 6%, they offer such investors the promise of relief, and they sound like a solid investment at a time when the U.S. is experiencing a domestic energy renaissance thanks to new shale-drilling technologies and the resulting natural-gas boom. But events at Boardwalk Pipeline Partners highlight the underlying risks and complexities in these investments, raising the question of whether these higher yields are really worth it.

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Shares of Boardwalk lost nearly half their value in one trading session back in February after the company, which is based in Houston and operates 14,450 miles of natural-gas pipelines and underground storage caverns, cut its cash payouts to unit holders by 80%. The company said its cash flows were under pressure due to a variety of macro factors. It now sports a dividend yield of 2.8% — little more than a 10-year Treasury. So, investors who were lured into the company by the promise of an attractive yield are now wishing they had settled for that plain-vanilla corporate bond.

Investors should first understand that MLPs aren’t corporations. They’re publicly traded partnerships that pass along most of their income to investors and enjoy a tax-exempt status granted by Congress, but limited only to companies operating cash-generating energy-infrastructure assets, like oil and gas pipelines and storage tanks. Last year, there was a record-breaking 21 initial public offerings of MLPs, and according to Morningstar, nearly $12 billion flowed into funds investing in MLPs — an all-time high.

Nat Worden

In other words, MLPs are a hot product these days. The financial industry always seems to come up with that mousetrap that too perfectly addresses the needs of the average investor in whatever investment climate comes along, and inevitably, things get out of control.

In this case, investors are starved for higher-yielding investment options, and there’s little to no interest-rate relief in sight for these people. Meanwhile, a recent report by Bloomberg News showed that Wall Street loves peddling MLPs, with all but five of 114 MLPs recommended by a majority of the research analysts offering coverage.

It’s never a good sign when such rosy sentiments become so widespread on Wall Street, but it all starts to make sense when you consider that MLPs have to borrow money and sell shares to grow, so they’re a boon to the banks and brokerages that employ most of the analysts recommending them. According to Bloomberg, bank fees for MLP deals last year totaled $890.3 million, led by Barclays Plc
BCS, +0.84%
with $126.7 million, Citigroup
C, -0.71%
with $96.7 million and JPMorgan Chase
JPM, -0.74%
with $78.2 million.

To be fair, MLPs have by and large been working as advertised. In the last five years, the S&P MLP Index has returned over 20% annually. For the sake of all those yield-seeking retirees who have bought into these things, I hope this performance continues. Some MLPs are no doubt solid businesses that will continue to be good investments for their partners, but I suspect that many investors are buying these products without a full understanding of their risks, and the recent gold rush in this sector may end badly for many.

For example, due to their structure, MLPs often pay out a higher dividend than they actually earn by issuing more stock and debt, which can lead to disaster. Sure enough, the number of MLPs with a distribution-coverage ratio below 1 — which suggests they’re distributing more cash to unit holders than they’re taking in — is growing, and this well-established trend is a major red flag. MLPs that currently have distribution-coverage ratios below 1 include Linn Energy
LINE, -15.13%
El Paso Pipeline Partners
US:EPB
and Enbridge Energy Management
EEQ, -0.60%
according to MLPData.com.

Another aspect to consider is the fact that there’s a lack of standard accounting rules for MLPs when it comes to reporting important financial metrics, which has been the source of a heated controversy at Kinder Morgan Energy Partners
US:KMP
one of the largest MLPs. As a result, MLPs have adopted many different approaches to reporting their maintenance capital expenditures — the cost of maintaining assets they own and operate. This is a key figure for determining MLPs’ distribution-coverage ratios, which helps gauge the size of a company’s financial cushion for maintaining its cash payouts to unit holders.

Investors are fooling themselves in assuming that dividend payouts from MLPs are safe and sustainable, and Boardwalk is a case in point. Demand for the company’s pipelines shifted upon renewal of their contracts, and their revenue and earnings plummeted, illustrating the real business risks facing these assets. It is an example that show that investors need to fully understand a space before investing in it, or they may find themselves facing unwanted surprises.

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